The personal blog of Adam Nash

Where No Fed Has Gone Before

There has been a lot of sensationalist talk in the past two weeks since the Bear Stearns acquisition by JP Morgan Chase. I’ve seen editorials slamming the Fed for doing too little, for doing too much, for not acting soon enough, and for acting at all.

However, I’ve seen pitifully few articles that actually explain the details of what the Federal Reserve did, and why it was so revolutionary for the almost 100-year old institution. Sure, I’ve seen commentators refer to a “$30 Billion Bailout” of Bear Stearns, especially in the context of populist rhetoric that this somehow would justify spending $30 Billion to bail out homeowners who are under-water on their mortgages. But this isn’t really a bailout.

First, the Federal Reserve action, although structured like a loan, actually seems to behave mathematically more like equity:

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

More detail follows down the page:

Here’s how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there’s money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that’s financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn’t seem to provide for the Fed to make such equity investments. That doesn’t trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed’s founding legislation, a “discount” of a “note.”

This is an important point, because if the history of liquidity-impacted portfolios like LTCM are any indication, it’s very likely that an orderly disposal of the Bear Stearns assets could actually net gains in the long term. More importantly, since JP Morgan takes the first $1B in losses, the Fed actually gets a bye on the first 3.3% of net loss on the portfolio, if it exists.

Now, you could argue that the Fed has put $29B of taxpayer dollars at risk, and that is true in a sense. But the value of that risk is not the $29B number thrown around, but a complex calculation of the actual expected gain/loss here. As I mentioned, historically, these type of crunch-induced crisis portfolios actually net out positively when given the time to unwind outside of a panic situation.

The fairest criticism I’ve seen of this action to date is the result of the raised offer from $2/share to $10/share by JP Morgan, which will not only keep Bear Stearns credit holders whole, but will also net common shareholders something of a windfall. You could argue that shareholders should have received nothing, and that credit holders should have born the first risk traunche of the portfolio.

The problem with this argument is that it assumes that any other deal could have been workable and accepted in the limited timeframe caused by the run on Bear assets & liquidity. These situations always seem calmer from hindsight, and beg for Monday-morning quarterbacking, but the truth is, they are negotiated in the heat of panic, and the almost audible sound of an approaching, falling knife.

3 thoughts on “Where No Fed Has Gone Before”

I would say that the main issue here, which has led to the wide-spread discussion (both positive and negative) about the Fed action, is that Central banks are supposed to guide, manage and regulate commercial banks.

Thus, these banks have to adhere to the norms specified by the Fed. As a result, the Fed is sort-of obliged to rescue these banks in case of perceived systemic trouble.

In this case, the Fed has come to the rescue of an Investment Bank, which is NOT regulated by the Fed.

That is a big departure from the norm, and therefore, these widespread comments!